Thursday, December 9, 2010

The Nature of Audit Risk and Materiality

Audit risk is the risk that the financial statements are materially misstated and the auditor fails to detect such a misstatement. The auditor must perform the audit to reduce audit risk to a low level.

Audit risk is a function of two components :

  1. Risk of material misstatement, which is the risk that an account or disclosure item contains a material misstatement, and
  2. Detection risk, which is the risk that the auditor will not detect such misstatements.

To reduce audit risk to a low level requires the auditor to :

  1. Assess the risk of material misstatement, and, based on that assessment,
  2. Design and perform further audit procedures to reduce overall audit risk to an appropriately low level.

The concept of materiality recognizes that some matters are more important for the fair presentation of the financial statements than others. In performing your audit, you are concerned with matters that, individually or in the aggregate, could be material to the financial statements. Your responsibility is to plan and perform the audit to obtain reasonable assurance that you detect all material misstatement, whether caused by error or fraud.

The accounting standards define Materiality as the magnitude of an omission or misstatement of accounting information that, in light or surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed by the omission or misstatement.

Thus, materiality is influenced by your perception of the needs of financial statement users who will rely on the financial statements to make judgments about your client.

ISA 320 Materiality in Planning and Performing an Audit, in paragraph A1 states that :

In conducting an audit of financial statements, the overall objectives of the auditor are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and to report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor’s findings. The auditor obtains reasonable assurance by obtaining sufficient appropriate audit evidence to reduce audit risk to an acceptably low level.

Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of the risks of material misstatement and detection risk.

Materiality and audit risk are considered throughout the audit, in particular, when :

  1. Identifying and assessing the risks of material misstatement;
  2. Determining the nature, timing and extent of further audit procedures; and
  3. Evaluating the effect of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report.

Source : WILEY – Practitioner’s Guide to GAAS 2010, Steven M.Bragg and ISA 320 Materiality in Planning and Performing an Audit

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